Natural Performers

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When it comes to currency risk, companies are going natural. No, that doesn’t mean they’re exposing themselves completely to risk. They are forsaking derivatives for natural hedges — matching revenues and costs for the same currency or offsetting losses in one currency with gains in another.

There are two main reasons for this shift, and probably a third. One, most multinationals have centralized their treasury operations, at least on a regional basis. With access to data from intercompany and third-party transactions within the various countries in which a multinational operates, risk managers can better understand how transactions in one currency offset those in another, and thus erect natural hedges.

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The second reason, closely allied with the first, is the cost of derivatives, which can become prohibitive if they are used to excess. “Some companies hedge themselves into oblivion,” observes Christos Pantzalis, an associate professor of finance at the University of South Florida. “You don’t want to run that risk,” agrees Gail Sullivan, treasurer of The Gillette Co., noting that hedging everything can lead to costs greater than those of unhedged exposures.

A third reason why companies are going natural may be the burdens associated with FAS 133, the Financial Accounting Standards Board’s three-year-old standard for accounting for derivatives. The rules require (1) that financial instruments be marked to market instead of reported at historical cost, and (2) that gains and losses on those instruments be included in earnings when they can’t be shown to effectively hedge an exposure. Moreover, FAS 133 makes it more difficult to use one derivative instrument to offset another. Merely conducting the tests required to determine a hedge’s effectiveness can eat up lots of time and money, as reflected in FASB’s implementation guidelines, which run several hundred pages.

It’s not clear whether companies are in fact cutting down on derivative use as a result of FAS 133, but recent studies by the Association for Financial Professionals suggests they may be doing so. What is clear is that companies can, and do, use natural hedges to greatly reduce transaction exposure — the impact of currency fluctuations on cash flows.

Natural hedges are less effective, however, at reducing translation risk — the impact of variations in exchange rates on a multinational’s reported earnings and shareholders’ equity. Such hedges aren’t available to limit the translation exposure of investments in foreign subsidiaries — but then, financial derivatives are often too costly on that front as well.

The Razor Company’s Edge

Gillette, which has some 60 percent of its sales coming from outside the United States, uses its in-house bank in Zurich to centralize and net transaction risk, according to treasurer Sullivan. The residual net transaction exposure is hedged primarily through forward contracts. As for translation risk, Gillette no longer makes much use of derivatives for managing this risk as far as earnings are concerned, says Sullivan. “Gillette’s basic policy on that is to use more of the natural types of hedging,” she says. Those hedges mainly involve pricing and sourcing policies.

Expense and earnings volatility are Gillette’s prime considerations here. “The cost of hedging earnings [with financial instruments] on an ongoing basis is worth taking on only if you feel that the volatility that you will have in your earnings will somehow preclude you from making investments that are necessary,” says Sullivan. She notes that the company isn’t in that position.

The challenge of hedging translation risk to earnings with financial derivatives is compounded by the fact that the dollar tends to move in broad cycles against other major currencies, typically lasting five to seven years, notes Jeff Wallace, the managing partner of Greenwich Treasury Advisers, in Greenwich, Connecticut. “If one consistently hedges [revenues and expenses] in a major currency with forwards, one could have five years of losses on those forwards,” says Wallace. “And that is difficult for any corporate to keep doing.” That’s particularly true as a result of FAS 133, which makes it harder to use hedge accounting for such instruments and thus avoid having to subtract such losses from reported earnings.

At some companies, to be sure, the use of financial hedges began to decline in anticipation of FAS 133. The amount of currency forward contracts held by Procter & Gamble Co., for instance, fell by almost half during the year that ended June 30, 1999, to $1.9 billion in notional value from $3.4 billion in fiscal 1998. And their value declined by another $110 million or so in fiscal 2000. While the company chalked up much of the reduction in 1999 to the disappearance of local currencies by countries embracing the euro, P&G also cited in its 10-K for that year “increased efficiencies in our hedge program.” The company attributed the decline in 2000 exclusively to better hedging as a result of centralization. (It should be noted that P&G suffered a huge hit in the early 1990s from a bad derivatives bet, which helped prompt FASB to produce FAS 133 in the first place.)

Still, experts say other companies have become better hedgers as a result of FAS 133. “There is less [financial] hedging, but better hedging,” asserts Wallace.

Consider, for instance, Movado Group, Inc., which is based in the United States but designs, manufactures, and distributes watches in Switzerland. With many of its costs incurred in Swiss francs, the company hedges that exposure through a combination of forward contracts, purchased currency options, and spot purchases. But according to its treasurer, Frank Kimick, Movado also uses natural hedges whenever possible. And while he notes that some companies are still quick to eliminate natural hedges if they believe a currency is going to move in their favor, “I always prefer to take advantage of them,” he says.

Losing Balance

Neither centralization nor natural hedges, however, can insulate corporate balance sheets from currency exposure. Consider Gillette’s experience before the U.S. dollar began falling in value last year. The currency-driven decline in the value of its investments in foreign subsidiaries took a significant toll on its shareholder equity from 1997 through 2001, when the dollar was gaining value against many foreign currencies. During that period, Gillette’s shareholder equity fell 54 percent, from $4.8 billion to $2.1 billion. And 20 percent of that was the result of losses from foreign-currency translation.

Until cost-cutting efforts began to take effect about a year ago, in fact, credit analysts were worried about Gillette’s balance sheet, and some remain concerned that a large debt-financed acquisition would undo the improvements in its financial condition. Granted, some credit analysts pay little heed to changes in shareholder equity. “It’s not a primary focus when we analyze companies,” says Fitch Ratings’s Karen Lynch Ghaffari.

Elsewhere, however, the measure is followed more closely. “If shareholder equity falls far enough, creditors will become concerned,” notes Charles W. Mulford, an accounting professor at Georgia Institute of Technology’s Dupree College of Management. And as recently as the quarter that ended March 31, 2001, Gillette’s return on equity was only 14.5 percent — some 10 points below the average ratio for competitors that got the same A+ credit rating as Gillette from Egan-Jones Ratings.

To be sure, Gillette does use currency forward contracts and debt instruments to hedge against the translation risk posed by assets primarily in countries where interest rates are lower than in the United States. “We hedge that exposure, because we will benefit from lower interest costs and our exchange on that hedge will offset our net investment in that country,” says Sullivan. But that formula doesn’t work in countries where rates are higher than U.S. rates. As a consequence, three such markets — the United Kingdom, Argentina, and Brazil — accounted for a significant portion of Gillette’s losses from this type of currency risk from 1997 until 2001. At present, says Sullivan, Gillette hedges against this risk from only three currencies: the Japanese yen, the Swiss franc, and the Taiwanese dollar.

Eastman Kodak Co. has had a similar experience. From 1999 to 2001, the company’s shareholder equity declined by 26 percent, from $3.9 billion to $2.9 billion. And about a third of that decline was due to currency-translation losses that weren’t offset by the company’s hedging efforts. In comparison, P&G’s losses from foreign currency translation from 1999 through 2001 averaged almost $500 million per year, only 4 percent of the company’s roughly $12 billion in shareholder equity during the period.

Falling Arrow

Such losses aren’t limited to large multinationals. Arrow Electronics, for instance, gets $2.5 billion of its $10 billion in revenues from Europe, with operations in 19 countries on that continent, and makes use of financial instruments when it can’t take advantage of natural hedges. Nevertheless, Arrow has experienced a loss of $98.8 million in 2001, which accounted for two-thirds of its decline in shareholder equity that year, to $1.8 billion from $1.9 billion in 2000. And its shareholder equity in 2000 would have risen by another $65.6 million had it not been for a currency translation loss that year.

Movado fared a bit better. Its currency translation losses of roughly $21 million between 1997 and 2002 did not prevent its shareholder equity from increasing 60 percent during the same period, from $104 million to $172 million. Yet the rise would have been even greater if not for those losses.

Of course, the swings in shareholder equity due to currency translation would have been greater still at these companies without their hedging efforts. However, Gillette, for one, has decided that the benefit of hedging all of this exposure isn’t worth the cost. But even Gillette doesn’t go completely exposed. “If you don’t hedge your net investment in a country, you’ll have a balance-sheet exposure, and that could grow to be significant,” warns Sullivan.

In other words, multinationals seem determined to hedge all their transaction risk but are letting more and more translation risk take care of itself. That may not be a problem as far as earnings are concerned, but when it comes to their balance sheets, they have to keep their fingers crossed.

Sidebar: Derivative Decline

The use of financial instruments to hedge risk has declined since FAS 133 took effect June 15, 2000, according to surveys conducted by the Association for Financial Professionals (AFP).

Much of the decline reflects the sharp fall in interest rates since then, since most financial hedges are intended to offset the risk of rising interest rates, and the survey found the biggest decline in the use of such instruments designed for that purpose. Fully 21 percent of the respondents to an AFP survey taken last September reported decreasing their use of derivatives for hedging interest-rate exposure since FAS 133 went into effect, compared with 7 percent that had increased their use.

But the survey also found a drop in currency-oriented derivative use, with 13 percent of the respondents reporting a decline in that type of hedging activity, against 12 percent who said they’d increased it. And as the table on page 39 shows, the use of financial instruments to hedge specific types of currency risk has declined across the board.

Some of the decline in currency hedging no doubt is a product of the advent of the euro, which has supplanted currencies in many European countries. But evidence also points to the increasing use of centralized treasury operations, which enable companies to take greater advantage of natural hedges. In addition, nearly half of the respondents to the AFP survey agreed that FAS 133 had imposed “an excessive” reporting burden on their companies.